The Dow Is Useless; Here's What's Useful

Odds are, if you've heard of any part of the U.S. stock market, you've heard of "the Dow" -- known by sticklers as the Dow Jones Industrial Average (DJIA). You may not know a lot about it, though.

On our discussion boards the other day, I ran across an interesting discussion of the Dow's merits and demerits. One poster succinctly noted that the Dow Jones Industrial Average is meaningless times four:

It is not representative of U.S. businesses and becomes less so every year.

It is weighted by per-share prices.

It ignores inflation (or "risk-free" rate of return; take your pick).

It omits dividends.

The fellow continued, saying, "If it were not for the idiot talking heads on the financial news, it would have faded into history long ago."

The truth is trueLet's tackle these points.

For starters, it's true that while many people (and newscasters, for that matter) assume the Dow represents the overall stock market, it really just reflects the performance of 30 companies. Only 30. Out of several thousand.

And even though many of those components include our biggest firms, such as ExxonMobil (NYSE: XOM) and Wal-Mart (NYSE: WMT) , a slew of biggies are necessarily excluded, such as Berkshire Hathaway, Time Warner (NYSE: TWX) , and Chevron (NYSE: CVX) . Moreover, nearly one-third of Dow components are "industrial" kinds of companies (think Caterpillar (NYSE: CAT) ), whereas such firms make up less than one-sixth of our economy.

Next is the issue of the Dow's being a price-weighted index. This means that it's tied to the prices of each component's stock. So the most influential companies in the Dow are those with the highest share prices. IBM (NYSE: IBM) was recently trading at a share price of $93, versus Microsoft (Nasdaq: MSFT) , trading around $29. Therefore, within the Dow, IBM is more than three times as influential, even though its market capitalization is around $140 billion, versus Microsoft's $290 billion. If any component firm splits its stock 2-for-1, it instantly becomes half as influential in the Dow, and it causes a dip in the Dow, as well. Does this make sense? Not much, to me. (Here's how the math works, by the way.)

Most major indexes, such as the S&P 500, are weighted by market capitalization, meaning that Microsoft, a twice as large company, would influence the index twice as much as IBM. Ahhh ... logic.

Next up, inflation. I'll concede that factoring inflation into Dow calculations could make it even more complicated and confusing. But it remains worth noting that when we examine the performance of any index -- or even our own portfolios -- we should consider inflation. Because if your return is 6% one year and inflation that year is 5%, you may not have gained as much ground as you thought.

Dividend oomphFinally, dividends. As with many indexes, their effect is ignored in the Dow, but their effect on our portfolios can be quite enormous. Here -- see how one Fool explained it in Retire Early With Dividends:

If you'd invested $1,000 in Altria in 1980, and reinvested your dividends along the way, today you'd be sitting on shares worth $145,776. Without dividends, you'd have a puny $45,711. Though back then you would have begun with a measly 29 shares of stock, you would now hold more than 2,150 shares through reinvested dividends and stock splits.

That's not bad, but here's the payoff pitch: From that single $1,000 investment, your shares would now provide an annual income of more than $6,300! Twenty-five years may seem a long time, but consider that you would have begun receiving your $1,000 original investment paid out to you annually in dividends in little more than 10 years.

The bottom line on dividendsSo what should we do about the Dow? Well, for starters, we might roll our eyes and sigh heavily every time an anchorperson notes that "The Dow rose 22 points today in heavy trading." Better still, we might do well to just ignore the index entirely.

Keep that lesson about dividends in your mind, though, because while the Dow may be rather irrelevant to your investment results, dividends can turbocharge them.

That's why you should consider seeking out and investing in companies with above-average yields and below-average prices. If you'd like a friendly pointer to some exceptional ones, know that those are exactly the types of companies we hunt for in our Income Investor newsletter. To see some of our best ideas, click here to take a 30-day free trial of Income Investor. There is no obligation to subscribe.

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